Business Overview: Year In Review 2006

Prices of oil and other commodities rose sharply, and merger activity in some sectors created new industry giants. The Big Three automakers struggled during the year, while in July Toyota surpassed Ford in U.S. sales for the first time. Boeing saw its prospects brighten in contrast to those of European rival Airbus. Most major world stock market indexes showed double-digit increases.

Historians might look back at 2006 as the year when the automobile era dominated by the Big Three automakers ended for good. Ford, General Motors, and, later in the year, DaimlerChrysler together faced massive layoffs, credit downgrades, declining sales, production slowdowns, botched alliances, and executive reshuffling in what made 2006 truly an annus miserabilis for the former kings of the auto industry.

Ford, which had been showing signs of recovery in 2005, began 2006 with hopes for continued improvement. Instead, it posted a first-quarter loss of $1.19 billion, in part because of a continued downturn in the popularity of sport utility vehicles (SUVs), which had been the linchpin of Ford’s sales. Ford’s operations continued to be at a serious cost disadvantage with respect to some of its international rivals. For example, in mid-2006 Ford’s Focus compact car commanded an average sales price of $13,990, about $3,000 less than the average compact car. Meanwhile, a Ford worker in 2005 earned about $65 an hour in wages and benefits, compared with roughly $47 an hour for a comparable Toyota worker. In July 2006 Toyota outsold Ford in monthly sales for the first time ever in the United States, and in the third quarter Ford posted a loss of $5.8 billion, its worst quarterly result in 14 years. Shaken to the core, Ford pushed forward its restructuring plan, made plans to reduce its North American workforce by 40% (through buyout offers to all 75,000 of its hourly workers), suspended its dividend payments in the fourth quarter, and began considering shuttering ailing brands such as Jaguar. In September, William Clay Ford, Jr., the great grandson of Henry Ford, gave up his position as CEO to an outsider—Alan Mullaly—a former senior executive of Boeing with little experience in automobiles. One of the first challenges Mullaly faced was a revolt by Ford’s auto-parts suppliers. Squeezed for years by Ford and the other Big Three firms for cost reductions, many of the suppliers—most recently Dana Corp.—had fallen into bankruptcy.

General Motors, which had a $10.6 billion net loss in 2005, found its condition in 2006 less dire. Early in the year GM sold a majority stake in General Motors Acceptance Corp. (GMAC), its profitable finance arm, to hedge fund Cerberus Capital Management. In 2004 GMAC had provided 80% of GM’s total net income. The cash infusion from the sale (believed to be in the range of $14 billion after various settlements) and a deal with the United Auto Workers to make buyout offers to 131,000 employees (47,600 were accepted) helped stabilize GM, and the company posted its first profitable quarter in two years. In June the company’s largest single shareholder, Kirk Kerkorian, proposed that GM enter into a partnership with two foreign automakers, Nissan Motor and Renault. Kerkorian’s belief was that GM would benefit from the insight of Carlos Ghosn, the renowned CEO of the two companies, and from reductions in supply-related costs that would result from the partnership. The initial proposal called for Nissan and Renault each to take a 10% stake in GM, but negotiations soon bogged down over how much Nissan and Renault would pay GM. GM’s board eventually weighed against the alliance, and the negotiations collapsed in October. GM continued to face cost hurdles; no American company besides GM was spending as much on employee health care—$5.4 billion in 2005, or roughly 0.4% of health care costs in the U.S. In 2005, for the first time, GM sold more vehicles outside North America than in its home market; South Korea was a particularly receptive market.

DaimlerChrysler stumbled when its Chrysler unit suffered a $1.5 billion operating loss in the third quarter, more than double its initial forecasts. It was a strange fate for a company that had begun the year with two profitable quarters and in the spring had even started to recall some laid-off employees. Chrysler shocked investors in September when it announced that it would cut its production schedule by 16% for the rest of 2006 because of sluggish sales. The entire DaimlerChrysler company reduced its profit forecast by about $1.2 billion, largely because of Chrysler’s misfortunes. The sources of Chrysler’s woes were the same as those that plagued its Big Three rivals: high gas prices, falling demand for SUVs and trucks, and growing benefit-related cost burdens.

By contrast, 2006 was a year of triumph for top Japanese automaker Toyota; it became the third biggest carmaker in terms of market share in the United States, a first for a foreign car manufacturer. Toyota’s victory over DaimlerChrysler for the year and, even more shockingly, over Ford in two months of sales, could be regarded simply as overtures to Toyota’s master plan, which was to outpace GM and become the world’s largest automaker by 2008. Toyota’s sales increases came at the expense of the Big Three. In July 2006 Toyota’s RAV4 outsold Ford’s Expedition SUV 14,755 units to 6,075, whereas in July 2005 the Expedition had outsold the RAV 15,733 to 7,394. Toyota opened its newest American manufacturing plant in San Antonio, which was relatively close to a top GM plant in Arlington, Texas. Although both plants had the same production capacity, Toyota’s labour cost was about $1,000 less per vehicle than GM’s, and its workforce was made up of 1,600 nonunion employees, compared with GM’s 2,800 United Auto Workers-affiliated employees.Toyota’s net income for the six months ended Sept. 30, 2006, rose by 32% to $4.25 billion. The company produced approximately 8.85 million vehicles globally in 2006 and planned to increase that total to 9.8 million by 2008. By comparison General Motors sold 9.2 million vehicles in 2005.

Toyota’s rise was not a solitary feat; besides Toyota, the other members of what the auto industry termed the J-Three, Nissan and Honda Motor, also had solid years. Honda said it planned to boost its worldwide annual car sales to 4.5 million by 2010, up from 3.4 million as of March 31, 2006, and that it expected at least one-third of that growth to come from North America. Nissan’s second-quarter profits soared by 31%, in part because of the sale of its stake in Nissan Diesel Motor to Volvo. The 12 top Japanese automakers for the first time produced more cars abroad than they did in Japan—having built 10.93 million vehicles abroad, compared with 10.89 million vehicles built in Japan for the year ended March 2006. The push toward overseas manufacturing was driven by a number of factors, including Japanese automakers’ desire to reduce shipping costs and currency-related complications.

The condition of European automakers was not nearly as solid as that of their Japanese counterparts. An exception was the surprise revival at Fiat, which boosted sales 19% in the first nine months of 2006 and recorded a profit. The largest European automaker, Volkswagen, earned $29.1 million in the third quarter and was attempting to reduce material costs by $1.3 billion by the end of the year.

For the first seven months of 2006, the airlines were on track to post their best overall performance since the Sept. 11, 2001, terrorist attacks. In the second quarter the industry posted an overall profit of $1.6 billion, and ridership was on the rise. Then came August, when British authorities foiled what they described as a plot by terrorists to destroy a number of aircraft in mid-flight. A host of London-based flights were grounded for days, and the repercussions of the shutdown were felt throughout the industry. British Airways canceled more than 1,100 flights, a disruption that reduced its annual profit by approximately $95 million. The prospect of further international disruptions cast a pall on the strategy of a number of U.S.-based airlines such as Delta Air Lines and Continental, which had expanded their cross-Atlantic service in a bid to increase ridership.

Terrorism-related troubles aside, the performance of American legacy airlines remained on the whole positive; AMR, the parent company of American Airlines, managed to post a $15 million net profit in the third quarter, whereas Continental, helped by a 17% increase in passenger revenue, posted $237 million in net income for the same period. Although US Airways Group, the newly merged US Airways–America West Airlines, reported a net loss of $78 million in the third quarter, its revenue had more than tripled to $2.97 billion.

Low-cost airlines, which had prospered over the past few years at the expense of the legacy airlines, faced their own challenges, including rising fuel costs and overexpansion. As a result, JetBlue Airways, Southwest Airlines, Spirit Airlines, and AirTran Holdings all increased fares in 2006, which in some cases made their fares more expensive than the corresponding ones of legacy carriers. JetBlue, blaming higher operating expenses, posted a $500,000 net loss in the third quarter, but Southwest’s third-quarter earnings slid 77%, to $48 million.

Many European and Asian airlines also faced challenges. Japan Airlines, for example, reported a group net loss of $93 million when the year began, and Singapore Airlines said that its 15% drop in profits in the July–September period was mainly the result of the $1.3 billion it spent on fuel in that period, a 27% year-on-year increase. There was some merger activity as well, as evidenced by Ryanair’s $1.8 billion hostile bid for its rival Irish airline Aer Lingus.

For the top two global aircraft manufacturers, 2006 was a tale of contrasts. Boeing, which had been tarred by scandal and eclipsed in performance by its international rival Airbus, returned to form, while Airbus had a year marked by misfortune. Boeing’s success was driven in part by its 787 Dreamliner model. The first new Boeing commercial airplane in a decade was set to go into service in 2008. The first three years of 787 production had already been sold, with 60 of 345 planes going to various Chinese airlines. Analysts expected that Boeing would easily recoup the $8 billion it and its partners had invested in developing the 787. The aircraft had a number of advantages for air carriers that were facing rising fuel costs. Its engines had fans of increased size that improved fuel efficiency, and its fuselage was made of a carbon-fibre hybrid, which was lighter than the aluminum fuselage of most aircraft.The skies were not entirely clear for Boeing, which posted a 31% drop in third-quarter earnings, in part because of its decision to kill its troubled in-flight Internet service. Boeing’s overall resurgence, however, spurred it to make its most substantial acquisition since the late 1990s—a $1.7 billion purchase in May of aircraft parts and service company Aviall. The deal was intended to bolster Boeing’s already-substantial aircraft-parts sales businesses, which generated $9 billion in sales in 2005.

Airbus had an ill-fated year largely because of problems with two of its models—the A380, which experienced a number of costly manufacturing delays, and the proposed A350, which faced criticisms from potential customers. In the summer Airbus announced that the A380, which would be the world’s largest passenger jet when completed, faced an additional six months in production delays that its owner, European Aeronautic Defence and Space (EADS), estimated would cost $2.5 billion in profits between 2007 and 2010. Worse, in October the A380 was delayed yet again, with EADS warning that the assembly-line problems would cut earnings by $6.1 billion over the 2007–10 period. The delays created chaos at Airbus’s top levels. Britain’s BAE Systems decided to exercise its right to force EADS to purchase BAE’s 20% stake in Airbus, ending a decades-old partnership and making EADS almost the sole owner of Airbus. Airbus CEO Gustav Humbert admitted that Airbus had underestimated the Boeing 787, and soon thereafter Humbert and co-CEO Noel Forgeard were forced out. The new Airbus CEO, Christian Streiff, lasted a mere three months before he resigned, his departure apparently prompted by disagreements with the Airbus board over the pace of the company’s turnaround program.

The energy sector had a topsy-turvy year that was marked by price fluctuations, changing political tides, and many high-volume mergers. Oil prices hit $70 a barrel in April, with gasoline prices in many parts of the U.S. at times hitting the $3-a-gallon mark. The price hikes had a number of causes, which included continued turmoil in the Middle East, the damage that Hurricane Katrina had wreaked on infrastructure in 2005, and China’s growing appetite for oil. (China’s crude-oil imports for the first half of 2006 were 15.6% higher than for the same period in 2005.) Another factor was the growing influence of energy-price speculators such as hedge funds and institutional money managers, who were betting on continually rising oil futures. Oil prices peaked at $77 a barrel in August and then began to tumble and reached a year low of $57 a barrel in late October before closing the year almost where they began, at $61.05.

Most top oil producers had another stellar year in terms of profits. ExxonMobil continued to post overwhelmingly large quarterly earnings, with $10.36 billion in the second quarter alone and $10.49 billion in the third quarter, the latter being the second largest quarterly performance by a publicly traded American company (the largest was Exxon’s $10.71 billion earnings in fourth-quarter 2005).

BP, in contrast, continually stumbled into controversy through the year. In June the company was sued by the U.S. Commodity Futures Trading Commission because its traders allegedly manipulated the price of propane in 2004. In August, five months after a 1,000,000-litre (270,000-gal) spill at one of its Alaskan pipelines, BP suddenly had to close down its Prudhoe Bay oil field—the largest in the U.S.—because of corroded pipes and a small leak. The shutdown, which contributed to the spike in oil prices to their year-high $77 a barrel, caused BP to reduce its production forecast for 2006 to 3.95 million bbl a day, compared with an earlier prediction of 4.1 million to 4.2 million. The Prudhoe Bay shuttering also was mainly responsible for BP’s 3.6% decline in profits for the third quarter, when it posted a still-substantial $6.23 billion in net income.

A continuing problem for the top oil companies was a growing wave of nationalism and its impact on untapped oil reserves. About 90% of the world’s untapped conventional oil reserves were owned either directly by governments or by government-controlled companies, such as Russia’s Gazprom, which in a matter of a few years supplanted the bankrupt Yukos to become Russia’s largest energy company and possessed the largest oil and natural-gas reserves worldwide. Gazprom flexed its newfound muscles in the natural-gas market in late 2005, when it briefly cut gas supplies to Ukraine in a pricing dispute, and again in December 2006, when it threatened to cut off gas supplies to Belarus and Georgia unless they agreed to much higher gas prices. In April Venezuela, the third largest OPEC producer, seized control of oil fields owned by France’s Total and Italy’s ENI and demanded more-favourable lease terms. In May Bolivia nationalized its natural gas industry after seizing control of all privately owned gas fields by military force.

At the same time, the oil industry proved merger-happy. Following on the heels of the merger-and-acquisition boom in 2005, when deals worth some $160 billion were announced, the energy sector witnessed some of its largest mergers since the late 1990s. Among them were Anadarko Petroleum’s $21.1 billion purchase of both Kerr-McGee and Western Gas Resources, for 40% and 49% over stock value, respectively.

Utilities continued to offer a mix of high profits, increased mergers, and political intrigues. The European Union’s desire to expand competition in the European energy sector by 2007 was countered by the attempts of national governments to prevent foreign takeovers of their top utilities. In February France pushed for an expensive ($37.9 billion) shotgun marriage between SUEZ and state-owned Gaz de France in order to block a bid for SUEZ by Italy’s Enel. The Spanish government attempted to foil a proposed bid by Germany’s utility E.ON for the Spanish utility Endesa. In September the European Commission ruled against Spain, and E.ON returned with a larger offer, about $47 billion, to purchase Endesa.

Mergers were also endemic in the American utility sector. Power companies that had been battered in the wake of the 2002 collapse of Enron Corp. came back with a vengeance. With the conviction of former Enron chairman Kenneth Lay and former president Jeffrey Skilling in May (and the death of Lay in July), the Enron story at last appeared over. Mirant, which went into bankruptcy protection in the post-Enron years, demonstrated new vigour with an unsolicited $7.9 billion bid for NRG Energy, although the deal foundered. Dynegy, another company that had had hard years in the early 2000s, pared its debt load down from $13 billion to $4 billion.

In the background, however, there was rumbling from the federal and state governments that the American utility sector had not dealt with its longer-term problems. A study by the North American Reliability Council found that electrical demand in the U.S. was rising three times faster than new resources were being added by utility companies, and state governments throughout the year held hearings to express concern about rising consumer rates in deregulated markets. Texas customers of the utility TXU, for example, experienced a rate increase of 80%.

The chemicals industry was recovering from a rough period marked by high energy costs and, in some cases, Hurricane Katrina-related damage to infrastructure. DuPont posted a $485 million profit in the third quarter, compared with an $82 million loss in the same period in 2005, and the largest American chemical maker, Dow Chemical, beat analyst estimates with a $512 million profit in the third quarter.

The metals sectors experienced major price increases and big-ticket mergers. In the metals and steel industry, 475 deals were announced in the first eight months of 2006 alone. A merger between the Russian aluminum producers RUSAL and SUAL Group and the aluminum unit of the Swiss firm Glencore International resulted in the formation of the largest global aluminum producer, with a 4.4 million- ton production capacity.

The price of nickel as of August 14 had risen 103% over the previous 24 months, and the nickel sector witnessed a complex series of deals. Phelps Dodge planned to purchase Inco Ltd. and Falconbridge Ltd. for a combined $40 billion, but the deal’s complexity eventually doomed it. Phelps and Inco ultimately merged, and Switzerland’s Xstrata purchased Falconbridge for $17 billion.

Gold futures prices hit a 26-year high on May 11, when gold hit an astonishing $732 an ounce. Fears about inflation, oil-price spikes, and terrorism spurred investors to drive gold to what proved to be unsustainably high prices. By October gold was trading at $582 an ounce, but it recovered to $635.20 (up 23%) at year’s end. The price mania earlier in the year spurred industry consolidation, such as Goldcorp’s $7.8 billion purchase of rival miner Glamis Gold to form the third largest global gold miner, after Canada’s Barrick Gold and the U.S.-based Newmont Mining.

Steel producers endured a high-octane combination of price fluctuations and massive consolidations. Steel prices rose substantially in the first six months of 2006, with cold-rolled steel in the U.S. hitting $700 a net ton in June, up from $590 a ton in June 2005, while steel imports in the first half were up 48%, to 17.58 million tons. By September, however, producers were publicly worrying about increasing stockpiles, a situation worsened by DaimlerChrysler’s production cuts and by growing imports by China, which by September were up 17% year on year.

The battle royal in the metals sector was between the industry’s two largest players; Arcelor spent much of the year attempting to fend off Mittal’s hostile takeover bid. At one point Arcelor floated the idea of aligning with Russia’s Severstal, but ultimately, after raising its offered price, Mittal acquired Arcelor in June for $33.84 billion. The deal created a steelmaking colossus, Arcelor Mittal, with a production capacity of 110 million tons, three times greater than its nearest rivals. The deal also spurred imitators, such as Tata Steel Ltd.’s $8 billion offer to buy Corus Group, the largest foreign acquisition ever by an Indian company.

The tobacco industry had a typical year marked by declining cigarette sales (the number of cigarettes sold in the U.S. was at a 55-year low) and endless court battles. For example, Altria’s Philip Morris USA appealed to the U.S. Supreme Court in a case in which an Oregon jury awarded a smoker’s widow $79.5 million in punitive damages. Tobacco companies did win a victory in July when the Florida Supreme Court upheld a lower court’s decision to throw out a $145 million class-action judgment against tobacco makers, but in September a federal judge in Brooklyn approved a class-action suit that targeted makers of “light” cigarettes for having deliberately misled consumers as to the actual nature of the products. Some companies moved into the smokeless tobacco market. For example, Reynolds American’s $3.5 million purchase of Conwood made it the second largest smokeless- tobacco manufacturer.

The livelihood of many drug manufacturers depended upon the decisions of governments and courts. Merck was fighting roughly 10,000 lawsuits that involved its withdrawn pain-relieving drug Vioxx. In April three separate jury decisions in Atlantic City, N.J., and Texas left Merck contending with $21.25 million in damages. In June Merck’s cholesterol-lowering drug Zocor went generic, which contributed to Merck’s 34% decline in profit in the third quarter (Zocor sales had totaled $4.4 billion worldwide in 2005). There was one bright spot for Merck—federal approval of its new diabetes medicine Januvia.

Bristol-Myers Squibb was left reeling when a deal it and France’s Sanofi-Aventis had forged with generic manufacturer Apotex fell apart. The deal would have delayed until 2011 Apotex’s generic version of Plavix, a blood thinner that was Bristol-Myers’s top-selling drug. After state attorneys rejected the deal, however, Apotex went on the offensive and began shipping generic versions of Plavix in August at 30% below Plavix’s retail price. The debacle cost Bristol-Myers at least $400 million in profits and also cost Bristol-Myers CEO Peter Dolan his job. The market share of generics was about 13% of the global drug industry, but not all name-brand-drug manufacturers were battling them. Pfizer, for one, said that it planned to offer its own generic version of Zoloft after the patent expired in June.

In Europe it appeared that nearly every mid-tier drug manufacturer was looking for a partner as drugmakers consolidated in order to better compete with the U.S.-based goliaths. Bayer purchased Schering for $19.7 billion; Merck KGaA bought Serono for $13.3 billion; and Nycomed acquired Altana for $5.6 billion.

Despite the summer oil-price shocks, stock markets in most major countries showed double-digit increases for the year, although Japan and South Korea lagged. In the U.S., the closely watched Dow Jones industrial average of 30 blue-chip stocks set 22 new records in the final quarter, and most international indexes closed 2006 at or near their high. (For Selected Major World and U.S. Stock Market Indexes, seeTable.)

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